Tuesday, 30 October 2012

When I wrote this,
I was reminded of a rather different but clearly related argument that I have
seen the Oxford philosopher (but also economist) John Broome make,[1]
although its fullest exploration is probably by Duncan Foley (pdf)[2].
The Stern report
clearly suggests that incurring the costs of mitigating climate change today will
raise the utility of future generations by more than it reduces ours.[3]
However the current generation appears unwilling to incur these costs.[4]
Let us call the ‘status quo’ the situation where nothing much is done to
prevent climate change, and so future generations suffer as a result.

Broome and Foley suggest that a Pareto improvement is
possible compared to the status quo. (A Pareto improvement is
a change where some people are better off, but no one is worse off.) This would
involve taking measures today to mitigate climate change, but getting future
generations to pay for it. How can this trick be pulled off? Following the
logic of the arguments I discussed here
and here
- that government debt involves a transfer between generations - we could pay
for climate change mitigation by issuing government debt, which would be
redeemed by future generations. Reducing CO2 emissions would not cost us
anything, because the money to pay for it would come from selling government
debt to the young. The cost would fall on future generations, who would have to
pay the higher taxes to either service the extra debt or pay it off. The Stern report
suggests future generations would prefer this outcome to the status quo,
because they would be prepared to pay to reduce climate change. It is therefore
a Pareto improvement compared to the status quo. Let’s call this the ‘debt
solution’.[5]

Now there is one immediate and powerful objection to the
debt solution, which is that future generations have to pay for something that this
generation is doing. It violates the polluter pays principle. This makes the
debt solution unfair or unjust. It would be fairer if the current generation
incurs the cost of mitigating climate change, just as it is right for a
company that pollutes a river to pay to clear up the pollution. Let us call
this the ‘just solution’.

The Stern review recommends that we move from the status quo
to the just solution. Unfortunately so far most governments, individually or
collectively, seem unwilling to do this. In these circumstances should we
instead at least start by implementing the debt solution, and then work on
achieving the just solution? Broome suggests “we should not encumber the
process of controlling climate change with the quite different matter of
transferring resources to future people.” That is a controversial suggestion:
many will feel that giving governments that option will reduce the chances of
achieving the just solution. But perhaps this is an example of where the best is the enemy of
the good.

[1]Broome’s paper is mainly about how we value the hopefully small chance of total
catastrophe, but the argument discussed in this post is made early on in that paper.

[3]
Stern argued that it was ethically wrong to value the utility of future generations less than our own. He values their consumption less, because they will be
better off and so require more consumption to achieve a certain level of
utility. Stern’s report was controversial among many economists because they
prefer to follow the supposed ‘revealed preference’ of the current generation to discount the utility of future generations.

[4] The
qualifier ‘appears’ is important here. My own, relatively uninformed, view of
the politics is that policy in this area is guided by particular vested
interests, rather than the collective view of the current generation. If it was
the case that the current generation was simply unwilling to make a present
sacrifice for future benefit, why is so much money spent on trying to discredit
the evidence about climate change?

[5] Government
debt probably crowds out productive capital to some extent, but this could be
offset if the money spent today involves increasing capital, in the form of
renewable energy generation for example.

Saturday, 27 October 2012

There has been some recent debate about whether UK austerity
is responsible for the poor performance of the UK economy (which remains poor,
despite the Q3 growth numbers). The debate could be summarised thus:

Austerity Critics (e.g. Paul
Krugman): “The UK has gone for strong austerity, and since it did so GDP
has stagnated – told you so.”

Austerity Apologists (e.g. Tyler
Cowen): “But if you ignore tax increases, and public investment, actually
there has not been much austerity. The weakness of the UK economy reflects
other factors.”

Austerity can involve tax increases, cuts in transfers and
spending cuts, so it is natural to look at the overall deficit. As I have
suggested before, the best figure for the direction and impact of policy is the
cyclically adjusted primary deficit. Both IMF and OECD estimates show substantial
austerity.

However any deficit figure may not be a good guide to the
aggregate demand impact of policy, because many tax and transfer changes will
have smaller multipliers than changes in spending on goods and services. As I
noted here,
the IMF suggest that UK austerity over the full 2009-2013 period is relatively focused
on government spending rather than taxes. However what about 2011 and 2012 in
particular? The table below looks at the government spending on consumption and
investment numbers that go into the national accounts.

Growth Rates in UK Government Spending on Goods and
Services, and Employment

The OBR’s forecast is quite old, but the new one will not
come out until 5th December. I’ve included the OECD’s June numbers because
their 2012 figure is a clear outlier
compared to other forecasts, and because many people (myself included) use these
forecasts. If they are right it will make a significant difference, but for the
rest of this post I’ll assume they are not, and use the OBR numbers.

Government investment makes up only about a tenth of
government spending on goods and services (G for short), so putting the two
together the OBR numbers suggest a fall in G of 1% in 2011, about flat in 2012
and a fall of almost 1.5% in 2013. So, the ‘contribution to growth’ of G to GDP
is to reduce it by a bit more than a quarter of one percent in 2011 and 2013,
with no impact in 2012. (OBR forecast (pdf),
Table 3.4.)

However this ‘contribution to growth’ number in effect
compares what actually happens to a counterfactual in which there was no growth
in G. A better counterfactual is if G had increased by, say, 2% a year in each
year, which would be a kind of neutral, average sort of figure.[6] On that basis cuts
in G directly reduce total GDP by about three quarters of a percent in
2011 and 2013, and by half of a percent in 2012. If the multiplier was only
one, these are still big numbers, but if it was two they become really large. It
would mean that the UK economy might have grown by over 2% in 2011 rather than
by less than 1%, without allowing anything for the impact of higher VAT.

So whichever way you look at it, it seems that austerity has
had a major impact on UK growth. Of course other things have been important
too, but I’m not sure anyone has actually claimed that austerity is the only thing holding back the UK economy.

But in one important sense this is all beside the point.
Those who criticise austerity only require three things to be true:

(1) Austerity is real, rather than something imaginary. The
figures above make that clear.

(2) Multipliers at the Zero Lower Bound are significant.

(3) If we had not had austerity, monetary policy would not
have offset stronger growth.[5]

This is why the multiplier debate is so important. There is
a lovely non-sequitur in Chris Giles FT piece
on this recently, which Jonathan and Richard Portes have already commented
on. Chris correctly notes that theory suggests that multipliers are larger if
interest rates are stuck at zero, and then says “so theory tells us very little
about the likely effect of fiscal policy on economic growth”. As I have argued many
times, theory is pretty clear that multipliers on G will be greater than one in
current circumstances, and could be a lot greater than one. And as Paul Krugman
quite rightly keeps reminding
us, it is theory that has stood up pretty well since the crisis.

[1]My
thanks to Jonathan Portes for some discussion on this issue, but I alone am responsible
for what appears here.

[4]
Final quarter of financial year, so 2011 figure is actually 2012Q1/2011Q1.

[5]
Unfortunately we cannot be certain that (3) is true, as I have discussed before.
However we cannot be certain the other way either, which is sufficient in my view to continue
to criticise UK austerity. [6] Postscript. We are interested in why the UK economy did not grow by, at the very least, 2% pa. So the natural counterfactual is where G grew in line with GDP at 2%. It is nonsense to say that G did not contribute to zero growth because it also did not grow.

Thursday, 25 October 2012

In a previous post
I talked about an example of the pernicious impact that politics can have on
academic economists, and promised to write something on how this might be
avoided. (For a more recent example, see here.)
Now one response to this is to shrug ones shoulders and say it is inevitable
given the nature of the discipline. It would certainly be naive
to imagine economics could ever be free of ideological influence. However I do not think it is unreasonable to
try and discourage situations where
evidence is distorted, and in particular to try and avoid occasions where minority
views are turned into policy because they happen to fit certain political
prejudices.

As I have argued before,
you cannot rely on the media to do this. Much of the media actually encourages
this problem, by giving minority views equal airtime. One of the really
depressing developments over the last decade has been how, when the issue of
climate change is in the news, the media often tries to ‘balance’ the views of some
climate change scientist with someone from the climate change denial community.

In the case of climate change, one way that scientists have
tried to overcome this problem is by ‘learned societies’ issuing reports. In
the US we have the National
Academies, and in the UK the Royal Society. Now it
is interesting to wonder whether economics could ever do something similar, but
you also have to ask how much that would achieve. As I have noted
before, no amount of expert opinion stopped certain newspapers in the UK hyping
the imagined link between the MMR vaccination and autism, and many politicians
worry more about what is in newspapers than what academic opinion says. Some
may even encourage
erroneous fears for political ends.

The problem in essence is this: on some issue with a
significant technical content (i.e. requiring expertise), there is a clear
majority amongst academia on what the answers are, but also some minority
opinion suggesting something different. Answers are correlated with political
preferences, so politicians pick the answers (and the advisors) that suit those
preferences, whether they are in a majority or minority. They face no comeback
from the media, who instead encourage the view that there are two, evenly
populated, sides. Now of course occasionally the minority view will turn out to
be the correct view, but most of the time it will not be. So how do we give
more weight to the majority view?

One answer is institutional delegation. The government sets
up a permanent body (or enhances an existing body) with the remit to focus on
the contentious issue. By establishing the institution itself, it gives it
political authority. The institution is designed as far as possible to be
politically neutral: indeed its survival to some extent depends on this,
because it wants to outlive any particular government. It is designed to be
transparent, which should help it to be resistant to lobbying interests
(including lobbying by the government). It may contain the expertise on the
issue, or it may find that expertise within places like the academic community.
Because it is non-partisan it can sort expertise from opinion, and distinguish
between majority and minority views.

The obvious example we have in macroeconomics is monetary
policy and central banks. In some ways this delegation was quite easy, because
the institution already existed, and it had operational control. However in
other respects it was more difficult to achieve, because delegation involved
giving complete power to the institution to determine policy. Governments just
set some general parameters, and sometimes a specific target. Independent
central banks are far from perfect, but if you think returning monetary policy
to governments would be a step forward, have a look at some of the strange ideas
gaining political currency in the US.[1]

By delegation I do not just mean politicians giving up
control. Instead the institution can be charged with providing expertise and advice.
The macroeconomic example here is the fiscal
council. The advice they provide may be quite specific and limited (as is
the case with the UK’s OBR
with macro forecasts) or more general and wide ranging (as with the CPB
in the Netherlands). There is no obligation for the government to follow that advice,
but it may bear a significant political cost
if it does not do so because the fiscal council has been established by
government to provide authoritative advice.

Sometimes a private institution can emerge to fulfil a
similar role, such as the Institute for Fiscal
Studies in the UK. However, this role can easily be contested,
by think tanks that have a clear political agenda. Here competition is a
problem. We already have plenty of competition over ideas: the failure is in
getting the better ideas adopted as policy. Whether delegation of advice can be
effective will depend on the political system in place. In countries where
large sections of the media can be bought,
there is less cost to ignoring such institutions, as the experience of the CBO
in the US shows (although the effectiveness of the CBO could be improved, as I
suggested here).
However in other countries with a more politically independent media, there is
a greater political cost in overriding advice from independent institutions set
up by government.

Macroeconomists have a standard argument for delegation in
the case of monetary policy, and various reasons why fiscal policy may be
subject to a deficit bias which delegation might avoid. What I am suggesting
here is a more general argument for delegation (which goes beyond economics) in
cases which mix technical expertise with political controversy.

A particular example where such delegation could be useful
is fiscal policy and demand stabilisation. This involves not just the austerity
versus stimulus debate, but the macroeconomics of how best
to achieve debt reduction with as little damage to growth as possible. One
argument against delegating decisions or advice in this area is that the
academic community is too evenly divided. I would make two observations. First,
I find much less division about fiscal stabilisation policy among those that
work in this area than among macroeconomists more generally. Second, would
there be so many arguing for austerity today if it was not for the politics of
the moment? (Recall that the previous US President used countercyclical policy
arguments as part of the case
for tax cuts.)

I used to think
that fiscal stabilisation issues could be delegated to the central bank, because
they know all about demand stabilisation.[2]
However the obsession in many central banks with budget deficits probably makes
this a bad idea (see the Netherlands).
It could be a supranational body like the IMF.
But at a national level the obvious alternative is a fiscal council. A fiscal
council’s main focus is long term debt control, which is an important issue in
its own right (which is why I wrote this)
and is sufficient justification to set up such a body. But although the focus
of their work should be on the long term, in practice they find they have to
spend some proportion of their time (often a very large proportion) on shorter
term issues. As a result, the possibility of short term fiscal demand
stabilisation could fall within their remit. They can be the apolitical institutional
filter that can sort out majority from minority opinion within academia.

[1]In
some ways the current debate over fiscal policy reminds me about how monetary
policy used to be debated thirty years ago. To which many would say that with
monetary policy we know better now, but I think one reason why our
understanding has improved is the role central banks play in fostering this
knowledge.

[2]The way the proposal would work is
that central banks would be allowed to change a select number of fiscal
instruments on a temporary basis. The time spans involved, and any limits on
the size of changes, would be established by government. When I once argued for this before a committee of UK
MPs, to say the idea was not popular among those MPs would be a definite
understatement. I did wonder at one stage whether they might ask for the Serjeant-at-Arms to take me to the Tower for undermining Parliament.

Tuesday, 23 October 2012

The question,
following the observation that UK real wages have fallen substantially, is “In
the traditional Keynesian story, stimulus lowers real wages through nominal
reflation. Is that the Keynesian view here? If so, why do
Keynesians believe that British real wages need to fall more than 8.5%?”

Actually I think this question has nothing especially to do
with the UK, and a great deal with Keynesian theory, or at least how Keynesian
theory is often taught. The problem in the UK and nearly everywhere else right
now is lack of aggregate demand, not the level of real wages. Why, asks Tyler,
are not more workers being hired if real wages are so low? Well low real wages
are having some effect – it is one factor behind the ‘productivity
puzzle’ that is widely discussed
in the UK. But when the problem is aggregate demand, low and declining real
wages will not ensure ‘full employment’. Firms may employ more labour, but
there is no reason to expect the labour market to clear.

I think what lies behind this question is the idea that
aggregate demand matters because
sticky wages are preventing the labour market clearing. So, to rephrase Tyler’s
question, falling UK real wages do not look very sticky, so where is the
problem? When I was studying macro, there were these debates about whether it
was sticky wages, or sticky prices, which underpinned Keynesian theory.

The answer I would give, at least at the zero lower bound
under inflation targeting, is neither. To get technical, imagine a toy model
with imperfectly competitive firms who set a constant mark-up on labour costs,
and a linear technology. Nominal wages could fall forever, but firms would cut prices
to match, so the real wage would not change. So the question is then whether
falling prices will raise aggregate demand. But why should they, particularly
if nominal interest rates are stuck at zero, and the central bank puts a lid on
expected inflation.

The price that is ‘wrong’ when aggregate demand is deficient
is the real interest rate. This is one area where New Keynesian theory has helped
sort out old Keynesian confusions. If falling wages and prices do nothing to
change real interest rates, then aggregate demand need not rise. And if
aggregate demand does not rise, unemployment can persist. But at the zero lower
bound, with a central bank mandated to target inflation (and a government
showing no signs of changing that mandate), the real interest rate cannot be
reduced. So expansionary fiscal policy is needed to raise demand, not lower
real wages. Or, in the case of the UK at the moment, contractionary fiscal policy
is currently reducing demand and therefore output.

Sunday, 21 October 2012

After the weekend march against UK austerity, I
saw a government minister on the TV justifying their fiscal plans. One of the
arguments he used was that it was necessary for the sake of our children. In
these circumstances I can quite understand the urge to dismiss such arguments
as invalid. Part of this urge comes from knowing that, in many cases, the
argument about debt being a burden on future generations represents simple
hypocrisy.

How do I know this? Because often exactly the same people championing
austerity also argue
that we cannot take action to reduce future climate change because the current costs
will be too great. The UK government’s spin
was that it would be the greenest government ever, but its policy is quite the opposite. The
Republican Party in the US also resists any action to reduce climate change
because of the current costs of doing so (at least when they are not denying
climate change exists). The connection? Both issues involve trading off costs
to the current generation (austerity, measures to reduce climate change) with
costs to future generations (higher taxes, climate change itself). If you
really believe that we must reduce debt right now (rather than after the
economy has recovered) because of the impact debt will have on future
generations, then you should also be doing everything you can right now to
reduce carbon emissions.

But just because some of those who use the ‘we are doing it
for our children’ argument to justify today’s austerity are doing so
hypocritically does not mean the argument is wrong. I will not go over why it
is not wrong again,
except to stress a point I do not think I have made forcefully enough before. Arguments
which look at the distributional implications of permanently higher government debt
(debt incurred but never repaid), and then ponder whether real interest rates will
or will not be higher than the growth rate, are analytically convenient but
practically irrelevant. There are many strong reasons, which have nothing to do
with intergenerational equity, why it would be foolish to not try and reduce
the high levels of government debt we currently have when the economy recovers,
and so additional debt issued today will need to be repaid (and not just financed) at some point in the not too distant
future.

However, although concerns about intergenerational equity
are valid, they are unlikely to be critical to the austerity debate. Probably
most major economic issues involve some element of redistribution, and in
practice the device
of compensating the losers is not an option. Take monetary policy, for example.
We currently have low real interest rates, which benefits some but harms
others. Do we let the fact that savers are worse off as a result of this policy
hinder the central bank from keeping interest rates low? Of course not.

In the case of reducing debt today through austerity, there
are other factors which have distributional consequences going in the other
direction. To the extent that we have austerity through lower investment in
infrastructure or education, it is the young more than the old that will be
hurt by this policy. As important, high unemployment among the young today can
have lasting effects (pdf, HT TC) on their welfare, and their children's welfare, as this study (pdf) shows. More generally, if DeLong
and Summers are right that the hysteresis effects of austerity today are
significant, then an entire future generation may be worse off as a result.

So it is not that ‘burden of debt’ arguments are wrong, but
that they are just not that important in the context of the current austerity
debate. The welfare loss to future generations of delaying debt reduction by
ten years is small relative to the massive loss of resources and welfare caused
by austerity today. If we are worried about future generations, a far cheaper
way of helping them is to take action to mitigate the impact of climate change.

Saturday, 20 October 2012

This is a really interesting chart from the IMF’s October
2012 Fiscal
Monitor (HT Antonio
Fatás). The red dots are the cyclically adjusted primary balance, the blue bars changes in government expenditure and the yellow bars changes in tax revenue.

It shows the extent of austerity (the red dots). Look how
ludicrous is the idea that Greece is not trying hard enough – their current and
planned fiscal contraction is literally off the scale! (Here
are similar numbers from the OECD.) But what I want to focus on, which this
chart clearly shows, is the tax and spend composition of austerity.

In many countries (Ireland, Spain and the UK) austerity is
concentrated on the expenditure side. In some (e.g. US) it is more evenly
balanced, while in a few (France in particular) it mainly takes the form of rising
taxes rather than lower spending. Now how you regard this depends crucially on whether
these measures are permanent or temporary (where by temporary, I mean lasting
around ten years or less).

If they are permanent, then this is largely a political
issue about the size of the state. Raising taxes protects the existing size of
the state (taking on board any distortionary costs that permanently higher
taxes may bring), while cutting spending aims to reduce the size of the state.
In terms of short run demand impact - which is obviously important given the
current state of demand deficiency in most countries - permanent tax and
spending changes will have similar effects.[1]

On the other hand, if these measures are temporary, then in
macroeconomic terms their impact will be rather different, because multipliers
are different. A very broad generalisation is that theory suggests multipliers
for spending cuts will be significantly higher than those for tax
increases. The simple idea
is that consumers will smooth the impact of income changes due to tax increases,
whereas cuts in spending go straight into reducing demand. In addition,
incentive effects on labour supply will be much less important if they are
temporary and output is demand constrained.

We need to be careful, however, because this is a
generalisation that applies to government spending on goods and services with a
high domestically produced content. If the decline in government spending
involves a temporary reduction in civil servants’ salaries, rather than
building fewer hospitals or roads, then it is much more like a tax cut. As
analysis later in the IMF’s report shows, cuts in wages make up a significant
proportion of spending cuts in Portugal, but not much in the UK, where cuts
in government investment are more important.

So are these austerity measures temporary or permanent? Normally
governments do not say. An exception is a much remarked upon feature of the
French austerity plans,
which is the introduction for two years of a new top tax rate of 75% on incomes
over €1m. We can be pretty sure that this is one group where the income effects
of tax increases on consumption will be largely smoothed away (which is good),
but where the incentive effects are the subject of debate which seems more
ideological than evidence
based. Of course whether such temporary tax measures will in fact be temporary
is a moot point, as the Bush tax cuts in the US illustrate.

In the absence of reliable information from governments,
people have to make their own assessments. In the initial stages of a crisis, if either
there is an unforeseen shock to government finances, or to the long run level
of output, then it may make sense to regard any austerity as permanent. However
as austerity proceeds, the goal is to get debt down from a high but sustainable
level to a lower sustainable level. In these circumstances a rise in taxes
(say) will be temporary, and will eventually be reversed as lower debt reduces
debt interest payments and therefore taxes.

So it seems likely that a good part of current austerity
plans involve temporary fiscal changes designed to reduce debt levels, and so
the differences between the multipliers of tax and spending changes will apply.
For countries like the UK, that have focused on spending cuts, the knock on
effects on output will be relatively large, whereas for countries like France
the impact of austerity may be more moderate (although still unwelcome).

[1]Spending cuts may still have a larger impact on domestic demand because
government spending tends to have a lower import content than private spending.

Friday, 19 October 2012

Right now, the IMF appears to some to be on the side of the
angels. Their self
criticism about the impact of austerity is both unusual and commendable in
equal measure. They also appear to recognise that pushing
Greece further than it can or should go is stupidity
of the highest order. They are producing some of the best policy orientated
empirical macro research at the moment (e.g. here
and pdf).
Yet this is the same IMF that in May co-hosted a conference
on Latvia that looked very much like a PR job for the benefits of short sharp
shock austerity. (For some links, see here
and here.)
The IMF’s attitude to austerity remains nuanced and country specific (as noted here,
for example).

I’m not going to try and see if those apparently different
views can be reconciled. Instead I will offer a more institutional explanation
for any apparent confusion. The first point to make is that the IMF is a very
large organisation: there are around 150 economists in the European department
alone, and that department is one of many: some
geographical, some functional (e.g. fiscal affairs, research). These are highly
trained, very bright and often very experienced macroeconomists: the shear
intellectual fire power can seem overwhelming.

The second point is that, for the moment, there seems to be
no strong rigid party line imposed from the top. The country teams that conduct
and write the annual Article IV reports appear to have a degree of
independence, and so they do not have to completely subordinate their analysis
to the political sensitivities of the Board or Managing Director (as was evident
for the UK, for example). There is far
from complete independence of course: there are mechanisms to try and ensure
some consistency of approach, but these mechanisms are not strong enough to achieve
total homogeneity.

With so many talented individual macroeconomists, with such
a diverse knowledge of particular economies, and in the absence of a strong
command and control structure, differences of opinion are not surprising.
Indeed, we might expect to see the range of opinion outside the organisation
(among academics and policymakers) reflected to some extent within. It would
also not be human if country teams were not just a little bit influenced by the
dominant macroeconomic perspectives within those countries. After all, the
influence of the IMF in most cases is marginal at best, so being attuned to
those perspectives is essential.

Having said all this, it might still seem puzzling to find
within one organisation such diversity over
time as we have seen in the last few years. In 2008/9 the IMF was calling for
expansionary fiscal policy to support the world economy, but by 2010 it was arguing for fiscal
consolidation. Now the pendulum is swinging back again. One explanation, to
possibly misquote a
British Prime Minister, is “events, dear boy, events”. In 2009 the panic was
the prospect of another Great Depression. In 2010 that possibly had receded,
but then the panic was Greece.

A deeper explanation is the argument that the default mode
within the IMF has in the past involved imposing austerity on governments that have
overspent. So the 2010 switch to advocating austerity was a return to familiar
ground. From this perspective it was the championing of stimulus during the
worst of the recession that was the more interesting development for the
organisation. To quote from the excellent account by Farrell and
Quiggin[1]

“The Keynesian resurgence was not entirely a product of the
crisis. A Keynesian analysis and associated prescriptions had already begun to
emerge in expert debate in January 2008, before the crisis proper hit. Dominique
Strauss-Kahn, the Managing Director of the IMF, had announced at Davos that “a
new fiscal policy is probably today an accurate way to answer the crisis",
prompting Larry Summers to note that “This is the first time in 25 years that
the IMF managing director has called for an increase in fiscal deficits"
[Giles and Tett, 2008]. Both Strauss-Kahn and the IMF's chief economist,
Olivier Blanchard, were pragmatic Keynesians, with a theoretical bent that differed
markedly from the previous consensus position at an institution notoriously
fond of advocating fiscal retrenchment for countries in difficulty.”

This change in position in 2008/9 probably reflects a
pragmatic yet informed response to the unique (after the 1930s) position that
the global economy found itself in, with interest rates at the Zero Lower
Bound. What is interesting is that the IMF was able to make this change,
despite its reputation for promoting fiscal discipline, while other
institutions such as the ECB or European Commission (and sections of academia)
were less adaptable. Perhaps in comparison the IMF was relatively free of
political influence, so basic Keynesian logic was able to win the day, but that
would just be speculation on my part. Anyhow, it is good to see this view
reasserting itself after the disastrous shift to austerity in 2010.

[1]Farrell, H and Quiggin, J (2012) Consensus, Dissensus and Economic Ideas: The
Rise and Fall of Keynesianism During the Economic Crisis.

Wednesday, 17 October 2012

Chris Dillow alerts
us to new claims
that the UK government’s finances were in a terrible state before the financial crisis.
Latest estimates from the IMF and OECD put the UK’s cyclically adjusted budget
deficit in 2007 at around 5% of GDP, and the usual suspects have used these
numbers to justify the theme that the Labour government was grossly
irresponsible in fiscal terms before the recession. Chris explains why this
might be quite acceptable to offset surpluses being run in the private sector.
However as these figures appear to contradict what I argued about the Labour
government’s fiscal record in this post,
I want to explore a little bit where this number comes from.

The actual budget deficit in 2007 was just under 3% of GDP. As I
argued in that earlier post, somewhat larger than the deficit required to keep debt
to GDP constant, and therefore larger than it should have been, but not outlandishly so. The debt to GDP ratio in 2007 was much the same as when Labour took office ten years earlier. So to get a cyclically adjusted deficit of around 5% from an actual deficit of below 3%, the IMF and OECD must be assuming that 2007 was a boom
year for the UK economy. That is exactly right – the OECD now estimates that UK
output was 4.4% above trend in 2007.

Funny how it didn’t seem like that at the time. Indeed, the
OECD in 2007 thought that the output
gap that year was about zero, which was pretty much the consensus estimate. In
which case the cyclically adjusted deficit would be much the same as the actual
deficit. So what is going on? Why have the OECD and IMF
changed their minds so radically about the state of the economy in 2007?

The answer, of course, is what happened after 2007. This was
not just the recession, but the lack of recovery thereafter, and the absence of
firms today saying they have spare capacity. I discussed the case of disappearing UK
potential output (the ability or desire to produce output if demand is there) in
this post.
It is the same issue as our apparently poor productivity performance since the
recession, which the longer it continues looks less like a temporary cyclical
decline.

Now the capacity to produce output does not evaporate
overnight. Capacity depends on three main things: capital, labour and
productivity. Earthquakes aside, machines that could produce output yesterday
can still do so today. The labour is still around, which is why we have high
unemployment. Productivity is about how efficiently we use labour and capital
to produce output. Once again, productivity should not fall overnight: we don’t
just forget how to produce things efficiently. But the growth rate of
productivity can fall to very low levels, if no innovation is taking place.

But even if productivity growth slowed dramatically after 2007,
it cannot explain why apparent productive capacity is so low today. So if we
believe productivity is really so low today, it must have started slowing down
before the recession. In other words, productive capacity in 2007 must have
been much lower than we thought at the time. Hence the actual level of output
must have been well above productive capacity, leading to current estimates of
a 4-5% positive output gap.

Three points follow from this. First, claims based on these
figures that UK fiscal policy was grossly irresponsible before the recession
are simply silly. None of the major institutions that analyse the macroeconomy
thought in 2007 that the UK was in the middle of a major boom. Even if we
assume that what the IMF and OECD now estimate about 2007 is correct, the
government – like these organisations – did not have a crystal ball. In 2007
they, and pretty much everyone else, thought the economy was close to trend,
and the government based their policy on that judgement. If the government at the time had tried to argue that the economy was in the middle of a major boom, they would have been ridiculed.

Second, 2007 did not feel like a boom, so maybe it was not. In
an overheating economy we normally see shortages pushing up wages and prices,
but that was not happening in 2007. To argue that, despite this, 2007 really
was a boom, you have to find reasons why it did not show up in inflation. Maybe
in time we will, but nothing obvious springs to mind. This is why the UK
productivity puzzle is so puzzling – it really does look as if we either have
to rewrite history, or productivity just disappeared in the recession.
Alternatively, of course, perhaps productive capacity today is really much more (and
the output gap much larger) than people currently think, as some have
suggested (most recently here).

Third, does this mean looking at cyclically adjusted budget
deficits is a bad idea, if the adjustment itself is so uncertain? The answer is
clearly no. It makes sense to run surpluses in a boom and deficits in a
recession. We do the best we can to estimate when we are in a boom and when we
are in a recession. Much of the time it is pretty obvious. It was obvious from
inflation data, for example, that periphery Eurozone countries were
experiencing boom conditions before the recession, and that therefore they
should have been running bigger budget surpluses. Sometimes, particularly in extraordinary
times like these, we may get things wrong, but that does not imply that we
should give up trying.